Pricing of Sovereign Credit Risk: Evidence from Advanced Economies During the Financial Crisis

Pricing of Sovereign Credit Risk: Evidence from Advanced Economies During the Financial Crisis. By C. Emre Alper, Lorenzo Forni and Marc Gerard

IMF Working Paper WP/12/24
January, 2012

Summary: We investigate the pricing of sovereign credit risk over the period 2008-2010 for selected advanced economies by examining two widely-used indicators: sovereign credit default swap (CDS) and relative asset swap (RAS) spreads. Cointegration analysis suggests the existence of an imperfect market arbitrage relationship between the cash (RAS) and the derivatives (CDS) markets, with price discovery taking place in the latter. Likewise, panel regressions aimed at uncovering the fundamental drivers of the two indicators show that the CDS market, although less liquid, has provided a better signal for sovereign credit risk during the period of the recent financial crisis.

IV. CONCLUDING REMARKS

This paper addressed the linkages and determinants of two widely used indicators of sovereign risk: CDS and RAS spreads. It focused on advanced economies during the recent financial crisis and the sovereign market tensions that followed. It showed strong co-movements between both series, especially for those countries that have come under significant market pressure. At the same time, arbitrage distortions have remained pervasive in the biggest economies. This suggests that the liquidity of the derivatives market is of paramount importance for CDS spreads to fully reflect sovereign credit risk. For those economies where the evidence stands in favor of a cointegration relationship, deviations from arbitrage have been long lasting, though in line with results in the literature. Also, CDS spreads were found to anticipate changes in RAS, suggesting that the derivatives market has been leading in the process of pricing sovereign credit risk. Regarding the role of fundamentals, we showed that variables related to fiscal sustainability are able to explain only a limited share of the variation of CDS spreads. Spreads seem to respond more to financial variables (such as domestic banking sector capitalization, short-term liquidity conditions, large-scale long-term bond purchases by major central banks) or purely global variables (global growth, global risk aversion, dummies for the different stages of the crisis).

These results refer to a specific group of advanced countries over a short span of time. They suggest that movements in CDS and RAS spreads need to be interpreted with caution. First, while in theory they should be strictly connected, CDS and RAS spreads do not, generally, follow the pattern suggested by the no-arbitrage condition. Moreover, they are affected by several factors, with global and financial considerations playing a dominant role, while at the same time leaving room for a large unexplained component. In general, however, CDS spreads seem to have provided better signals than RAS regarding the market assessment of sovereign risk: over the period covered by the analysis, they have led the process of price discoveries in those countries under market pressure and have been more correlated than RAS to those fundamentals that are expected to affect sovereign risk.

PDF here: http://www.imf.org/external/pubs/ft/wp/2012/wp1224.pdf

The Challenge of Public Pension Reform in Advanced and Emerging Economies

The Challenge of Public Pension Reform in Advanced and Emerging Economies. Prepared by the Fiscal Affairs Department

IMF
December 28, 2011

Summary: This paper reviews past trends in public pension spending and provides projections for 27 advanced and 25 emerging economies over 2011–2050. In constructing these projections, the paper incorporates the impact of recent pension reforms and highlights the key assumptions underlying these projections and associated risks. The paper also presents reform options to address future pension spending pressures in the advanced and emerging economies. These reforms—mainly increasing retirement ages, reducing replacement rates, or increasing payroll taxes—are discussed in the context of their role in fiscal consolidation, and their implications for both equity and economic growth. In addition, the paper examines the challenge of emerging economies of expanding coverage in a fiscally sustainable manner.

Executive Summary

Public pension reform will be a key policy challenge in both advanced and emerging economies over coming decades. Many economies will need to achieve significant fiscal consolidation over the next two decades. Given high levels of taxation, particularly in advanced economies, fiscal consolidation will often need to focus on the expenditure side. As public pension spending comprises a significant share of total spending, and is projected to rise further, efforts to contain these increases will in most cases be a necessary part of fiscal consolidation packages. Pension reforms can also help avoid the need for even larger cuts in pro-growth spending, such as public investment, and help prevent the worsening of intergenerational equity caused by rising life expectancies (at a pace faster than expected) and longer periods of retirement. Finally, some pension reforms, such as increases in retirement ages, can raise potential growth. Thus, while the appropriate level of pension spending and the design of the pension system are ultimately matters of public preference, there are several potential benefits for countries that choose to undertake pension reform. Against this background, this paper provides: (i) an assessment of the main drivers underlying spending trends over recent decades; (ii) new projections for public pension spending in advanced and emerging economies over the next 20 to 40 years; (iii) an assessment of the sensitivity of the country projections to demographic and macroeconomic factors, and risks of reform reversal; and (iv) country-specific policy recommendations to respond to pension spending pressures.

Pension spending is projected to rise in advanced and emerging economies by an average of 1 and 2½ percentage points of GDP over the next two and four decades, respectively, and is subject to a number of risks. During 2010–2030, increases in spending in excess of 2 percentage points of GDP are projected in nine advanced and six emerging economies. There is considerable uncertainty with respect to these projections, but risks are on the upside for a number of countries. Under a scenario where life expectancy is higher than anticipated—life expectancy projections have in the past underestimated actual increases—pension spending would be over 1 percentage point of GDP higher than projected in 2030 in five economies.  Under a low labor productivity scenario, pension spending would be over ½ percentage point of GDP higher in three economies. Sizable risks are also associated with implementing enacted reforms as well as contingent fiscal risks if governments have to supplement private pensions should these fail to deliver adequate benefits.

The appropriate reform mix depends on country circumstances and preferences, although increasing retirement ages has many advantages. It is important that pension reforms do not undermine the ability of public pensions to alleviate poverty among the elderly.  Raising retirement ages avoids the need for further cuts in replacement rates on top of those already legislated, and in many countries the scope for raising contributions may be limited in light of high payroll tax burdens. Longer working lives also raise potential output over time. In many advanced economies there is room for more ambitious increases in statutory retirement ages in light of continued gains in life expectancy, but this should be accompanied by measures that protect the incomes of those who cannot continue to work. In emerging Europe, one possible strategy would be to equalize retirement ages of men and women. In other emerging economies, where pension coverage is low, expansion of non-contributory “social pensions” could be considered, combined with reforms that place pension systems on sound financial footing, including raising the statutory age of retirement. Where average pensions are high relative to average wages, efforts to increase statutory ages could be complemented by reductions in the generosity of pensions. Where taxes on labor income are relatively low, increasing revenues could be considered, and all countries should strive to improve the efficiency of payroll contribution collections.

PDF here: http://www.imf.org/external/np/pp/eng/2011/122811.pdf

Are Rating Agencies Powerful? An Investigation into the Impact and Accuracy of Sovereign Ratings

Are Rating Agencies Powerful? An Investigation into the Impact and Accuracy of Sovereign Ratings. By John Kiff, Sylwia Nowak, and Liliana Schumacher
IMF Working Paper WP/12/23
Jan 2012
http://www.imfbookstore.org/ProdDetails.asp?ID=WPIEA2012023

Abstract

We find that Credit Rating Agencies (CRA)’s opinions have an impact in the cost of funding of sovereign issuers and consequently ratings are a concern for financial stability. While ratings produced by the major CRAs perform reasonably well when it comes to rank ordering default risk among sovereigns, there is evidence of rating stability failure during the recent global financial crisis.  These failures suggest that ratings should incorporate the obligor’s resilience to stress scenarios. The empirical evidence also supports: (i) reform initiatives to reduce the impact of CRAs’ certification services; (ii) more stringent validation requirements for ratings if they are to be used in capital regulations; and (iii) more transparency with regard to the quantitative parameters used in the rating process.

Excerpts
I. INTRODUCTION

1. Recent rating activities by the Credit Rating Agencies (CRAs) have induced some to ask whether ratings represent accurate risk assessments and to question how influential they are. The contention that ratings represent accurate default risk metrics was brought into question by the sheer volume and intensity of the multiple downgrades to U.S. mortgage-related structured finance securities in the wake of the crisis. Voices have also been raised against the timing of recent downgrades of European sovereigns amidst criticism that these downgrades promoted uncertainty in financial markets, leading to “cliff effects” and as a consequence affect their ability to funding themselves. Rating agencies have also been accused of behaving oligopolistically.

2. These criticisms are not new. CRAs’ downgrading actions have been accused before of not being timely but instead procyclical. It was argued that “the Mexican crisis of 1994-95 brought out that credit rating agencies, like almost anybody else, were reacting to events rather than anticipating them” (Reisen, 2003). During the late 1990s Asian crisis, CRAs were also blamed of downgrading East Asian countries too late and more than the worsening in these countries’ economic fundamentals justified, exacerbating the cost of borrowing.

3. The goal of this paper is to assess these concerns. We first examine CRAs’ role and whether CRAs are influential or just lag the market once new information is available and priced into fixed income securities. This is an important point. If CRAs influence the market, their opinions are important from a financial stability perspective. If they do not and just reflect information available to the market, their actions are not relevant and there is no policy concern.  In this regard, we test three hypotheses regarding the services that CRAs provide to the market: information, certification and monitoring. We find evidence that CRAs’ opinions are influential and favor the information and certification role. We then attempt to determine what ratings actually measure and how accurate they are. We conclude with some policy recommendations based on these findings. This study is limited to sovereign ratings (of emerging markets and advanced economies) and covers the period January 2005-June 2010.

4. Our analysis of the interaction between the market and CRAs indicates that ratings have information value beyond the information already publicly available to the market.  Specifically, the following results were evident:

• An event study shows that negative credit warnings (i.e., “reviews,” “watches,” and “outlooks”) have a significant impact on CDS spreads. This evidence is also supported by a Granger-causality test that finds that negative credit warnings Granger-cause changes in CDS spreads. These findings are consistent with the view that rating agencies do provide additional information to the markets, in addition to what is publicly available and used by markets to price fixed income securities.

• Although upgrades and downgrades in general do not have a significant impact on CDS spreads, upgrades and downgrades in and out of investment grade categories are statistically significant. This supports the view that the certification services provided by rating agencies do matter and likely create a purely liquidity effect (e.g.  purchases and sales of assets forced by regulations or other formal mandates and not based on the additional information already in the market).

• We do not find evidence in favor of the most important testable implication of the monitoring services theory. The impact of downgrades preceded by an outlook review in the same direction is not statistically significant. 

• From an informational point of view, the market appears to discriminate more than rating agencies among different kinds of issuers—in particular at lower rating grades and during crisis periods. This finding may indicate that ratings need to incorporate more granularity and leads to the second question of what ratings measure and how accurate they are.

• A common element among ratings by the major CRAs is that they represent a rank ordering of credit risk. This ordering is based on qualitative and quantitative inputs such as default probabilities, expected losses, and downgrade risk. However, there is no oneto- one mapping between any of these quantitative measures of credit risk and credit ratings. There is also no disclosure of the quantitative parameters that characterize each rating grade. For this reason, validation tests undertaken by outsiders can only apply to the ability of ratings to differentiate potential defaulters and non defaulters, but not to estimating cardinal measures such as default probabilities.

• The point highlighted above implies that—in spite of playing a similar role to internal ratings in the Basel II internal ratings-based (IRB) approach—ratings produced by the CRAs are subject to lower validation standards than are the banks using the IRB approach. In the Basel II IRB approach, financial institutions use measures of default probabilities (PD), losses given default (LGD) and exposure at default (EAD) to produce their internal ratings and are subject to calibration tests.  Although validation is foremost the responsibility of banks, both bank risk managers and bank supervisors need to develop a thorough understanding of validation methods in evaluating whether banks’ rating systems comply with the operating standards set forth by Basel II.

• Ratings produced by the major CRAs perform reasonably well when it comes to rank ordering default risk among sovereigns, i.e. defaults tend to take place among the lowest rated issuers. Accuracy ratios (AR) indicate that agencies are more successful at sorting out potential defaulters among sovereign issuers (average ARs in the 80 to 90 percent range) than among corporate and structured finance issuers (average ARs in the 63 to 87 percent range), the latter ones having suffered a strong deterioration over the global financial crisis. For all classes of products though, the ARs indicate that sovereign rating accuracy deteriorates as the evaluation horizon increases.

• In general, long-term credit transition matrices show that higher ratings are more stable than lower ones, and tend to remain unchanged. But this was not the case during the global crisis period, when there has been a tendency to see heavier downgrade activity among higher-rated sovereigns than among lower-rated ones. There has been evidence of significant rating failure (defined here as three or more rating changes in one year) during the recent global financial crisis, although less than in the Asian crisis.

IV. SOME POLICY RECOMMENDATIONS

• Based on the evidence of the impact of the CRA’s certification services, the removal of the excessive reliance of regulations on ratings is warranted. This will not affect the information value of ratings—that appears to work mostly through outlook reviews—and will help lessen the additional liquidity impact due to the need to meet regulations, reducing potential cliff effects.

• To the extent that ratings continue to play a significant role in regulations, an issue arises as to whether CRAs should be more transparent about the quantitative measures they calibrate in the rating process (PDs, LGD, and stability assumptions), how these measures are mapped into ratings, and whether the final ratings can be used to infer the parameters used to obtain these measures. This is particularly relevant in the use of external ratings by banks employing the standardized approach in Basel II since internal ratings systems are subject to rigorous back testing.

• Moreover, recent heavy downgrade activity suggests that ratings should embed the notion that risk is a forward looking dimension conditional on the macroeconomic scenario. In this regard, ratings should be better tied to macroeconomic conditions, including their resilience to stress scenarios.

PDF here: http://www.imf.org/external/pubs/ft/wp/2012/wp1223.pdf

Oil-price shocks have had substantial and statistically significant effects during the last 25 years

Measuring Oil-Price Shocks Using Market-Based Information. By Tao Wu & Michele Cavallo
IMF Working Paper No. 12/19
January 01, 2012
http://www.imfbookstore.org/ProdDetails.asp?ID=WPIEA2012019

Summary

We study the effects of oil-price shocks on the U.S. economy combining narrative and quantitative approaches. After examining daily oil-related events since 1984, we classify them into various event types. We then develop measures of exogenous shocks that avoid endogeneity and predictability concerns. Estimation results indicate that oil-price shocks have had substantial and statistically significant effects during the last 25 years. In contrast, traditional VAR approaches imply much weaker and insignificant effects for the same period. This discrepancy stems from the inability of VARs to separate exogenous oil-supply shocks from endogenous oil-price fluctuations driven by changes in oil demand.

Excerpts:

I. INTRODUCTION

The relationship between oil-price shocks and the macroeconomy has attracted extensive scrutiny by economists over the past three decades. The literature, however, has not reached a consensus on how these shocks affect the economy, or by how much. A large number of studies have relied on vector autoregression (VAR) approaches to identify exogenous oilprice shocks and estimate their effects. Nevertheless, estimation results generally have not provided compelling support for the conventional-wisdom view that following a positive oilprice shock, real GDP declines and the overall price level increases. In addition, the estimated relationship is often unstable over time. This is why, after a careful examination of various approaches, Bernanke, Gertler, and Watson (1997) conclude that “finding a measure of oil price shocks that ‘works’ in a VAR context is not straightforward. It is also true that the estimated impacts of these measures on output and prices can be quite unstable over different samples.”

Traditional VAR-based measures of oil-price shocks exhibit two recurrent weaknesses: endogeneity and predictability. With regard to the first one, VAR approaches often cannot separate oil-price movements driven by exogenous shocks from those reflecting endogenous responses to other kinds of structural shocks. For instance, the oil price increases that occurred over the 2002–2008 period were viewed by many as the result of “an expanding world economy driven by gains in productivity” (The Wall Street Journal, August 11, 2006). The occurrence of such endogenous movements will undoubtedly lead to biased estimates of the effects of oil shocks.

On the other hand, part of the observed oil price changes might have been anticipated by private agents well in advance. Therefore, they can hardly be considered as “shocks.” Most measures of oil-price shocks in the literature are constructed using only spot oil prices. However, when the market senses any substantial supply-demand imbalances in the future, changes in the spot prices may not fully reflect such imbalances. A number of authors (e.g., Wu and McCallum, 2005; Chinn, LeBlanc, and Coibon, 2005) have found that oil futures prices are indeed quite powerful in predicting spot oil price movements, indicating that at least a portion of such movements may have been anticipated at least a few months in advance. Both these concerns underscore the need to pursue a different approach to obtain more reliable measures of exogenous oil-price shocks.

In this paper, we combine narrative and quantitative approaches to develop new measures of exogenous oil-price shocks that avoid the endogeneity and predictability concerns. We begin by identifying the events that have driven oil-price fluctuations on a daily basis from 1984 to 2007. To achieve this goal, we first collect information from daily oil-market commentaries published in a number of oil-industry trade journals, such as Oil Daily, Oil & Gas Journal, and Monthly Energy Chronology. This leads to the construction of a database that identifies the oil-related events that have occurred each day since January 1984. We then classify these daily events into a number of different event types based on their specific features, such as weather changes in the U.S., military actions in the Middle East, OPEC announcements on oil production, U.S. oil inventory announcements, etc. (see Table 1). Next, for each event type we construct a measure of oil-price shocks by running oil-price forecasting equations on a daily basis. Finally, shock series from exogenous oil events are selected and aggregated into a single measure of exogenous oil-price shocks. By construction, these shock measures should be free of endogeneity and predictability problems, and statistical tests are also conducted to confirm their exogeneity. For robustness, we also provide a number of alternative definitions of exogenous oil-price shocks and construct corresponding shock measures for each one of them.

We employ our new, market-information based measures to study the responses of U.S. output, consumer prices, and monetary policy to exogenous oil-price shocks. We also compare the estimated responses with those obtained following two traditional VAR-based identification strategies that are very popular in the literature. Estimation results reveal substantial and statistically significant output and price responses to exogenous oil-price shocks identified by our market-based methodology. In contrast, responses implied by the VAR-based approaches are much weaker, statistically insignificant, and unstable over time. Moreover, we find that following a demand-driven oil-price shock, real GDP increases and the price level declines. This finding is consistent with scenarios in which oil-price fluctuations are endogenous responses to changes in the level of economic activity rather than reflecting exogenous oil shocks. We argue that traditional VAR-based approaches cannot separate the effects of these two kinds of shocks and consequently lead to biased estimates of the dynamic responses.

Our approach is similar in spirit to the narrative approach pursued in a number of existing studies. Romer and Romer (2004, 2010) adopt it in their analyses of monetary policy and tax shocks, Alexopoulos (2011) and Alexopoulos and Cohen (2009) in the context of technology shocks, and Ramey (2009) in her analysis of government spending shocks. With regard to oil-price shocks, several earlier studies have tried to isolate some geopolitical events associated with abrupt oil-price increases and examine their effects on the U.S. economy. Hamilton (1983, 1985) identifies a number of “oil-price episodes” before 1981, mainly Middle East tensions, and concludes that such oil shocks had effectively contributed to postwar recessions in the U.S. Hoover and Perez (1994) revise Hamilton’s (1983) quarterly dummies into a monthly dummy series and find that oil shocks had led to declines in U.S. industrial production. Bernanke, Gertler, and Watson (1997) construct a quantitative measure, weighting Hoover and Perez’s dummy variable by the log change in the producer price index for crude oil, yet they were not able to find statistically significant macroeconomic responses to oil shocks in a VAR setting. Hamilton (2003) identifies five military conflicts during the postwar period and reexamines the effects of the associated oil shocks on U.S. GDP growth. Finally, Kilian (2008) also analyzes six geopolitical events since 1973, five in the Middle East and one in Venezuela, and examines their effects on the U.S. economy. Our study contributes to the literature by constructing a database of all oil-related events on a daily basis. This allows us to identify all kinds of oil shocks and conduct a more comprehensive analysis than earlier studies. Extracting the “unpredictable” component of oil-price fluctuations using an oil futures price-based forecasting model represents another novelty of our work.

More recently, Kilian (2009) has also used information from the oil market to disentangle different kinds of oil-price shocks. In particular, he has constructed an index of global real economic activity, including it in a tri-variate VAR, along with data on world oil production and real oil prices. Using a recursive ordering of these variables, he recovers an oil-supply shock, a global aggregate demand-driven shock, and an oil market-specific demand shock.  Although his approach is completely different from ours, the effects on the U.S. economy of all three kinds of structural shocks estimated in his work are quite close to our empirical estimates.  This, in turn, corroborates the validity of our approach. We present detailed evidence in subsequent sections.

Our study is also related to the ongoing debate about how the real effects of oil-price shocks have changed over time. For instance, VAR studies, such as those of Hooker (1996) and Blanchard and Galí (2009), have usually found a much weaker and statistically insignificant relationship between their identified oil-price shocks and real GDP growth in the U.S. and other developed economies during the last two to three decades. These results are often cited as evidence suggesting that the U.S. economy has become less volatile and more insulated from external shocks, the result of better economic policy, a lack of large adverse shocks, or a smaller degree of energy dependence (e.g., a more efficient use of energy resources and a larger share of service sector in the U.S. economy), all contributing to a “Great Moderation” starting in the first half of the 1980s. Although we do not challenge this general characterization of the “Great Moderation,” our estimation results reveal a substantial and significant adverse effect of exogenous oil shocks on the U.S. economy, even during the last two and a half decades. Results from VAR studies, in particular the time variation in coefficient estimates, may simply reflect an inadequate identification strategy.

V. CONCLUDING REMARKS

This paper combines narrative and quantitative approaches to examine the dynamic effects of oil-price shocks on the U.S. economy. To correctly identify exogenous oil shocks, we first collect oil-market related information from a number of oil-industry trade journals, and compile a database identifying all the events that have affected the global oil market on a daily basis since 1984. Based on such information, we are able to isolate events that are exogenous to the U.S. economy and construct corresponding measures of exogenous oil-price shocks.  Furthermore, shock magnitudes are calculated by running a real-time oil-price forecasting model incorporating oil futures prices. These procedures help alleviate the endogeneity and predictability problems that have pestered the traditional VAR identification strategies in the literature.

One contribution of our work is the thorough examination of all kinds of oil-related events in the past two and a half decades, more comprehensive than just focusing on geopolitical or military events, as most of the earlier literature has done so far. Moreover, in constructing the database, we have preserved as much primitive information on the oil-market developments as possible, with the hope of facilitating possible future studies by other researchers on the nature and implications of these events. 

After deriving our measures of various kinds of oil shocks, we go on to examine their dynamic macroeconomic effects. We find that exogenous oil-price shocks have had substantial and statistically significant effects on the U.S. economy during the past two and a half decades. In contrast, traditional VAR identification strategies imply a substantially weaker and insignificant real effect for the same period. Further analysis reveals that this discrepancy is likely to stem from the inability of VAR-based approaches to separate exogenous oil-supply shocks from endogenous oil-price fluctuations driven by changes in oil demand. Notably, our study also suggests that the U.S. economy may not have become as insulated from oil shocks during the last two and a half decades as earlier studies have suggested. To examine fully how the oil price-macroeconomy relationship has evolved during the whole postwar period, a thorough study along the same narrative and quantitative approach for the period prior to the “Great Moderation” is called for. This will be the topic for future research.

Volatility, rather than abundance per se, drives the "resource curse" paradox

Commodity Price Volatility and the Sources of Growth. By Tiago V. de V. Cavalcanti, Kamiar Mohaddes, and Mehdi Raissi
IMF Working Paper No. 12/12
http://www.imfbookstore.org/ProdDetails.asp?ID=WPIEA2012012

Summary

This paper studies the impact of the level and volatility of the commodity terms of trade on economic growth, as well as on the three main growth channels: total factor productivity, physical capital accumulation, and human capital acquisition. We use the standard system GMM approach as well as a cross-sectionally augmented version of the pooled mean group (CPMG) methodology of Pesaran et al. (1999) for estimation. The latter takes account of cross-country heterogeneity and cross-sectional dependence, while the former controls for biases associated with simultaneity and unobserved country-specific effects. Using both annual data for 1970-2007 and five-year non-overlapping observations, we find that while commodity terms of trade growth enhances real output per capita, volatility exerts a negative impact on economic growth operating mainly through lower accumulation of physical capital. Our results indicate that the negative growth effects of commodity terms of trade volatility offset the positive impact of commodity booms; and export diversification of primary commodity abundant countries contribute to faster growth. Therefore, we argue that volatility, rather than abundance per se, drives the "resource curse" paradox.


Excerpts

I. INTRODUCTION

Finally, while the resource curse hypothesis predicts a negative effect of commodity booms on long-run growth, our empirical findings (in line with the results reported in Cavalcanti et al.  (2011a) and elsewhere in the literature) show quite the contrary: a higher level of commodity terms of trade significantly raises growth. Therefore, we argue that it is volatility, rather than abundance per se, that drives the "resource curse" paradox. Indeed, our results confirm that the negative growth effects of CTOT volatility offset the positive impact of commodity booms on real GDP per capita.

VI. CONCLUDING REMARKS

This paper examined empirically the effects of commodity price booms and terms of trade volatility on GDP per capita growth and its sources using two econometric techniques. First, we employed a system GMM dynamic panel estimator to deal with the problems of simultaneity and omitted variables bias, derived from unobserved country-specific effects.  Second, we created an annual panel dataset to exploit the time-series nature of the data and used a cross-sectionally augmented pooled mean group (PMG) estimator to account for both cross-country heterogeneity and cross-sectional dependence which arise from unobserved common factors. The maintained hypothesis was that commodity terms of trade volatility affects output growth negatively, operating mainly through the capital accumulation channel.  This hypothesis is shown to be largely validated by our time series panel data method, as well as by the system GMM technique used, suggesting the importance of volatility in explaining the under-performance of primary commodity abundant countries.

While the resource curse hypothesis postulates a negative effect of resource abundance (proxied by commodity booms) on output growth, the empirical results presented in this paper show the contrary: commodity terms of trade growth seems to have affected primary-product exporters positively. Since the negative impact of CTOT volatility on GDP per capita is larger than the growth-enhancing effects of commodity booms, we argue that volatility, rather than abundance per se, drives the resource curse paradox.

An important contribution of our paper was to stress the importance of the overall negative impact of CTOT volatility on economic growth, and to investigate the channels through which this effect operates. We illustrated that commodity price uncertainty mainly lowers the accumulation of physical capital. The GMM results also implied that CTOT volatility adversely affects human capital formation. However, this latter effect was not robust when we used an alternate GARCH methodology to calculate CTOT volatility. Therefore, an important research and policy agenda is to determine how countries can offset the negative effects of commodity price uncertainty on physical and human capital investment.

Another notable aspect of our results was to show the asymmetric effects of commodity terms of trade volatility on GDP per capita growth in the two country groups considered. While CTOT instability created a significant negative effect on output growth in the sample of 62 primary product exporters, in the case of the remaining 56 countries (or even in the full sample of 118 countries) the same pattern was not observed. One explanation for this observation is that the latter group of countries, with more diversified export structure, were better able to insure against price volatility than a sample of primary product exporters.  Finally, we offered some empirical evidence on growth-enhancing effects of export diversification, especially for countries whose GDP is highly dependent on revenues from just a handful of primary products.

The empirical results presented here have strong policy implications. Improvements in the conduct of macroeconomic policy, better management of resource income volatility through sovereign wealth funds (SWF) as well as stabilization funds, a suitable exchange rate regime, and export diversification can all have beneficial growth effects. Moreover, recent academic research has placed emphasis on institutional reform. By establishing the right institutions, one can ensure the proper conduct of macroeconomic policy and better use of resource income revenues, thereby increasing the potential for growth. We await better data on institutional quality to test this hypothesis. Clearly, fully articulated structural models are needed to properly investigate the channels through which the negative growth effects of volatility could be attenuated. This remains an important challenge for future research.

CPSS-IOSCO's Requirements for OTC derivatives data reporting and aggregation: final report

Requirements for OTC derivatives data reporting and aggregation: CPSS-IOSCO publishes final report
January 17, 2012
http://www.bis.org/press/p120117.htm

The Committee on Payment and Settlement Systems (CPSS) and the Technical Committee of the International Organization of Securities Commissions (IOSCO) have published their final report on the OTC derivatives data that should be collected, stored and disseminated by trade repositories (TRs).

The committees support the view that TRs, by collecting such data centrally, would provide authorities and the public with better and more timely information on OTC derivatives. This would make markets more transparent, help to prevent market abuse, and promote financial stability.

The final report reflects public comments received in response to a consultative version of the report published in August 2011. Following the consultation exercise, the report was expanded to elaborate on the description of possible options to address data gaps.

The report was also updated to reflect recent international developments in data reporting and aggregation requirements stemming from the Legal Entity Identifier (LEI) workshop in September 2011 and other efforts under the auspices of the Financial Stability Board (FSB), in support of a request by the G20 at the Cannes Summit, to advance the development of a global LEI.

As the report indicates, some questions remain regarding how best to address current data gaps and define authorities' access to TRs. As requested by the G20, two internationally coordinated working groups will address these questions in the coming year. The FSB will establish an ad hoc group of experts to further consider means of filling current data gaps, while the CPSS and IOSCO will establish a joint group to examine authorities' access to trade repositories.


Report Background

The report addresses Recommendation 19 in the October 2010 report of the FSB, Implementing OTC derivatives market reforms, which called on the CPSS and IOSCO to consult with the authorities and the OTC Derivatives Regulators Forum in developing:

(i)    minimum data reporting requirements and standardised formats, and

(ii)   the methodology and mechanism for data aggregation on a global basis. A final report is due by the end of 2011.

The requirements and data formats will apply both to market participants reporting to TRs and to TRs reporting to the public and to regulators. The report also finds that certain information currently not supported by TRs would be helpful in assessing systemic risk and financial stability, and discusses options for bridging these gaps.

Issues relating to data access for the authorities and reporting entities are discussed, including methods and tools that could provide the authorities with better access to data. Public dissemination of data, it is noted, promotes the understanding of OTC derivatives markets by all stakeholders, underpins investor protection, and facilitates the exercise of market discipline.

The report also covers the mechanisms and tools that the authorities will need for the purpose of aggregating OTC derivatives data.


Notes to editors

• This report was originally published in August 2011 as a consultative report.
• The CPSS serves as a forum for central banks in their efforts to monitor and analyse developments in payment and settlement arrangements as well as in cross-border and multicurrency settlement schemes. The CPSS secretariat is hosted by the Bank of International Settlements (BIS).
• IOSCO is an international policy forum for securities regulators. The Technical Committee, a specialised working committee established by IOSCO's Executive Committee, comprises 18 agencies that regulate some of the world's larger, more developed and internationalised markets. Its objective is to review major regulatory issues related to international securities and futures transactions and to coordinate practical responses to these concerns.
• Both committees are recognised as international standard-setting bodies by the Financial Stability Board (www.financialstabilityboard.org)

The sustainability of pension schemes

The sustainability of pension schemes, by Srichander Ramaswamy
BIS Working Papers No 368
http://www.bis.org/publ/work368.htm


Abstract

Poor financial market returns and low long-term real interest rates in recent years have created challenges for the sponsors of defined benefit pension schemes. At the same time, lower payroll tax revenues in a period of high unemployment, and rising fiscal deficits in many advanced economies as economic activity has fallen, are also testing the sustainability of pay-as-you-go public pension schemes. Amendments to pension accounting rules that require corporations to regularly report the valuation differences between their defined benefit pension assets and plan liabilities on their balance sheet have made investors more aware of the pension risk exposure for the sponsors of such schemes. This paper sheds light on what effects these developments are having on the design of occupational pension schemes, and also provides some estimates for the post-employment benefits that could be delivered by these schemes under different sets of assumptions. The paper concludes by providing some policy perspectives.


8  Summary and policy issues (edited)

A weak macroeconomic environment and unusually low real interest rates in many countries have put the funding challenges faced by occupational and public pension schemes in the spotlight. This paper took a simple actuarial model to quantify how the cost of funding DB pension schemes increase as the real rate of return in asset markets falls. If real returns on pension assets are assumed to be lower by 0.5% compared to their historical averages, service costs of DB schemes would be 15% higher than in the past for the same benefit payments. Converting final salary pension schemes to career average schemes (and not altering the percentages applied) would lower pensions by 20–25% assuming that real wages grow at the rate of 1–1.5% per annum.

Declining mortality rates will put further upward pressure on the contribution rates needed to fund these schemes. When the expected increases in longevity are priced into the actuarial model for computing the service cost, this cost is likely to be 10% higher than estimates presented in the paper. Increasing longevity as well as demographic changes that point to a rise in the old-age dependency ratio poses challenges to the sustainability of PAYG schemes. The projected increase in old-age dependency ratio suggests that in many countries the contributions to PAYG schemes have to increase by 20% from current levels in 2020 to pay pensions. But as PAYG schemes that service current pensions from employee contributions and taxes do not report the contractual pension liabilities, estimating the funding shortfalls these schemes might face going forward is a challenge.

In contrast to PAYG schemes and some funded public pension schemes, occupational DB schemes have to comply with accounting standards to report the market value of their pension liabilities and the assets that back them so that potential funding shortfalls faced by these schemes can be quantified. Unusually low real interest rates and poor financial market returns in the past decade have had an adverse impact on the coverage ratio of these schemes through the valuation effects on liabilities and lower returns on pension assets. Estimates of the coverage ratio of occupational DB schemes based on these returns would point to a funding deficit of 10 to 20 per cent against their pension liabilities. The size of any deficit that eventually materialises over the long lives of these schemes, however, would depend on future returns – which are unknown.

For occupational DB schemes that face large funding shortfalls, employer contributions will have to rise to improve the coverage ratio of these schemes. At the same time, increasing longevity and falling real yields against the backdrop of a weak macroeconomic environment are raising the service costs of DB schemes and adding to the upward pressures on required contribution rates. Recent amendments to pension accounting standards, which require companies to provide more disclosures in their financial statements on the risks the DB scheme poses to the entity and to report the net gains or losses from their DB pension plans on their balance sheet, are likely to accelerate the shift out of occupational DB plans into DC plans. This is because DC plans limit the contractual liabilities of employers to the contribution rates to be paid for the current service period of the employee.

A progressive shift from DB to DC schemes can have material implications for post-employment benefits because it exposes employees to the investment risks on the pension assets. In addition to this risk, beneficiaries of DC plans will also be exposed to the principal risk factors that determine annuity payments, namely level of real interest rates and the projections of mortality rates into the future when the actual annuity payments will be made. Using a simple model to estimate the retirement income from DC schemes, the numerical results presented in Table 2 showed that when contributions to DC schemes are 18% of salaries over a 30-year period and the returns net of administrative expenses on plan assets are 2% higher than the rate at which wages grow, post-employment benefits from a DC scheme would roughly be 43% of the final salary. The excess return assumption of 2% is based on the following input variables in the model to compute retirement income for DC plans: real yield on long-term bonds is 2%; equity risk premium over the returns on long-term government bonds is 3%; plan assets have an equal share of bonds and equities; administrative expenses are 0.5% of plan assets; and the annual real wage growth rate is 1.25%.

The quantitative analysis presented in this paper provides some insights on the possible trade-offs that may be available for public policy on the design of sustainable pension schemes. For example, the internal rate of return on the notional assets of PAYG schemes will be approximately equal to the rate of real GDP growth of the local economy, which is expected to be 2% or lower in advanced economies. The actuarial model showed that service cost of a pension scheme will be high when the rate of return on the pension assets is low. A funded public pension scheme, on the other hand, will be able to raise the level of return on pension fund assets by investing them in higher growth markets. Estimates using the actuarial model suggest that a 50 basis points increase in real returns lowers the service cost of the pension scheme by 15%. Funded pension schemes therefore offer the prospect of lowering service costs and to be able to better align the pension benefits offered by these schemes to the contribution rates received.

Public policy may also be needed to develop efficient markets for pricing annuity risk as occupational DC plans become the preferred post-employment benefit scheme offered by employers. Efficient markets for pricing annuities will in turn depend on how the market for managing and hedging longevity risk develops. As more employers progressively shift towards DC schemes for providing post-employment benefits, regulatory policies might be needed to restrict the range of permissible investment options available for plan assets to avoid unintended risks being taken by the plan beneficiaries, and to set mandatory minimum contribution rates for participating in DC schemes. Finally, considering that plan beneficiaries in DC schemes are exposed to interest rate risk at the time of converting plan assets into an annuity, the pros and cons of providing insurance policies that guarantee a minimum real yield at which these assets can be converted into an annuity will have to be examined.

BCBS: Application of own credit risk adjustments to derivatives - consultative document

Application of own credit risk adjustments to derivatives - Basel Committee consultative document
December 21, 2011
http://www.bis.org/press/p111221.htm

The Basel Committee today issued a consultative document on the application of own credit risk adjustments to derivatives.

The Basel III rules seek to ensure that a deterioration in a bank's own creditworthiness does not at the same time lead to an increase in its common equity as a result of a reduction in the value of the bank's liabilities. Paragraph 75 of the Basel III rules requires a bank to "[d]erecognise in the calculation of Common Equity Tier 1, all unrealised gains and losses that have resulted from changes in the fair value of liabilities that are due to changes in the bank's own credit risk".

The application of paragraph 75 to fair valued derivatives is not straightforward since their valuations depend on a range of factors other than the bank's own creditworthiness. The consultative paper proposes that debit valuation adjustments (DVAs) for over-the-counter derivatives and securities financing transactions should be fully deducted in the calculation of Common Equity Tier 1. It briefly reviews other options for applying the underlying concept of paragraph 75 to these products and the reasons these alternatives were not supported by the Basel Committee.

The Basel Committee welcomes comments on all aspects of this consultative document by Friday 17 February 2012. Comments should be sent to baselcommittee@bis.org. Alternatively, comments may be submitted to the following address: Basel Committee on Banking Supervision, Bank for International Settlements, Centralbahnplatz 2, 4002 Basel, Switzerland. All comments may be published on the BIS website unless a commenter specifically requests confidential treatment.


Summary (http://www.bis.org/publ/bcbs214.htm, edited):

A deterioration in a bank's own creditworthiness can lead to an increase in the bank's common equity as a result of a reduction in the value of its liabilities. The Basel III rules seek to prevent this. Paragraph 75 of the Basel III rules requires a bank to "[d]erecognise in the calculation of Common Equity Tier 1, all unrealised gains and losses that have resulted from changes in the fair value of liabilities that are due to changes in the bank's own credit risk". The application of paragraph 75 to fair valued derivatives is not straightforward since their valuations depend on a range of factors other than the bank's own creditworthiness. The consultative paper proposes that debit valuation adjustments (DVAs) for over-the-counter derivatives and securities financing transactions should be fully deducted in the calculation of Common Equity Tier 1. It briefly reviews other options for applying the underlying concept of paragraph 75 to these products and the reasons these alternatives were not supported by the Basel Committee.

PDF: http://www.bis.org/publ/bcbs214.pdf

2011: A Year of Important Pharmacological Advances for Patients

2011: A Year of Important Pharmacological Advances for Patients
December 21, 2011
http://www.innovation.org/index.cfm/NewsCenter/Newsletters?NID=193

New advances in biopharmaceuticals came as welcome good news for U.S. patients. In recent years, despite increasing investments in R&D, fewer medicines have recieved approval, reminding us just how difficult drug discovery is. But in 2011 there were more new medicines approved than in recent years and these approvals represented important advances in many areas.

The Food and Drug Administration reported in November that in fiscal year 2011 (10/1/10–9/30/11) there were 35 new medicines approved,[i] among the highest in the last decade. According to the FDA report, "few years have seen as many important advances for patients." The final tally of medicines approved in calendar year 2011 waits to be seen but it is clear that 2011 has been a great year for advancing the fight on many disease fronts. Below is information on some of the treatments highlighted in the FDA report.

Cancer: With improvements in early detection and a steady stream of new and enhanced treatments cancer can be more effectively managed and even beaten. Two new personalized medicines for lung cancer and melanoma now provide effective options for patients with tumors expressing certain genetic markers.[ii] The personalized melanoma treatment and another new melanoma medicine became the first new approvals for the disease in 13 years. Read about continued efforts to improve cancer treatment and the 887 medicines currently in development.

Rare Diseases: An estimated 25-30 million Americans suffer from rare or "orphan" diseases, which are often among the most devastating to patients and complex for researchers.[iii] However, advances in science have allowed us to hone in on the causes of many rare diseases and translate those findings into new treatments. Between January 1st and December 7th 2011, eleven new medicines to treat rare diseases were made available to patients for diseases such as the genetic defect congenital Factor XIII deficiency, several cancers, and scorpion poisoning.[iv] A record 460 new medicines are in clinical trials or awaiting FDA review.[v] Read more about the ongoing commitment to improve treatment for rare diseases.

Lupus: Lupus is a serious and potentially fatal autoimmune disease that attacks healthy organs and tissues of the body. For the approximately 300,000 to 1.5 million lupus sufferers in the U.S. the last approved drug came in 1955. This year a newly approved medicine ended that drought with a new approach to treating lupus. Read more about medicines in development for autoimmune diseases.

Hepatitis C: Hepatitis C is a chronic viral disease that affects the liver and can lead liver cancer and liver failure. It affects approximately 3 million people in the United States. Two new medicines approved this year are the first in a new class and offer a greater chance of cure for some patients compared with existing therapies. For more information on medicines in development for infectious diseases, click here.

This is only a partial list of the many advances approved in 2011, for a more complete listing visit www.FDA.org.

Looking ahead to 2012, biomedical research continues to draw us in new directions and helps us to better understand the cause and progression of disease. Coupled with innovative approaches at the bench and in the clinic, we can better prevent, detect, and treat disease to save and improve lives.


References
[i]US Food and Drug Administration, FY2011 Innovative Drug Approvals, (November 2011) http://www.fda.gov/AboutFDA/ReportsManualsForms/Reports/ucm276385.htm

[ii]US Food and Drug Administration, FY2011 Innovative Drug Approvals, (November 2011) http://www.fda.gov/AboutFDA/ReportsManualsForms/Reports/ucm276385.htm

[iii]PhRMA, Orphan Drugs in Development for Rare Diseases (February 2011) http://www.phrma.org/sites/default/files/878/rarediseases2011.pdf

[iv]US Food and Drug Administration, CDER New Drug Review: 2011 Update (December 2011) http://www.fda.gov/downloads/AboutFDA/CentersOffices/OfficeofMedicalProductsandTobacco/CDER/UCM282984.pdf

[v]PhRMA, Orphan Drugs in Development for Rare Diseases (February 2011) http://www.phrma.org/sites/default/files/878/rarediseases2011.pdf

BCBS: revised "Core principles for effective banking supervision" - consultative paper

Consultative paper on revised "Core principles for effective banking supervision" issued by the Basel Committee
December 20, 2011
http://www.bis.org/press/p111220.htm

The Basel Committee on Banking Supervision today issued for public comment its revised "Core principles for effective banking supervision" [http://www.bis.org/publ/bcbs213.htm].

The consultative paper updates the Committee's 2006 "Core principles for effective banking supervision" [http://www.bis.org/publ/bcbs129.htm] and the associated "Core principles methodology" [http://www.bis.org/publ/bcbs130.htm], and merges the two documents into one. The Core Principles have also been re-ordered, highlighting the difference between what supervisors do themselves and what they expect banks to do: Principles 1 to 13 address supervisory powers, responsibilities and functions, focusing on effective risk-based supervision, and the need for early intervention and timely supervisory actions. Principles 14 to 29 cover supervisory expectations of banks, emphasising the importance of good corporate governance and risk management, as well as compliance with supervisory standards.

Among other things, the revision of the Core Principles builds on the lessons of the last financial crisis. The Core Principles have been enhanced to strengthen supervisory practices and risk management. In addition, the revised Core Principles respond to several key trends and developments that emerged during the last few years of market turmoil: the need for greater intensity and resources to deal effectively with systemically important banks; the importance of applying a system-wide, macro perspective to the microprudential supervision of banks to assist in identifying, analysing and taking pre-emptive action to address systemic risk; and the increasing focus on effective crisis management, recovery and resolution measures in reducing both the probability and impact of a bank failure.

Ms Sabine Lautenschläger, Co-chair of the Core Principles Group and Vice-President of the Deutsche Bundesbank, noted that "the revised Core Principles contribute to the broader ongoing effort by the Basel Committee to raise the bar for banking supervision in the post-crisis era". She added that "the Committee has achieved a lot in terms of rule-making over the past five years and this work will be instrumental in firmly entrenching many of the supervisory lessons and regulatory developments since the Core Principles were last revised".

The latest revision ensures the continued relevance of the Core Principles in providing a benchmark for supervisory practices that will withstand the test of time and changing environments. The total number of Core Principles has increased from 25 to 29; 36 new essential and additional criteria have been introduced and another 33 additional criteria have been upgraded to essential criteria that represent minimum baseline requirements for all countries.

The Core Principles are the de facto framework of minimum standards for sound supervisory practices and are universally applicable. The Committee believes that implementation of the revised Core Principles by all countries will be a significant step towards improving financial stability domestically and internationally, and provide a good basis for further development of effective supervisory systems.

"With the advent of various policy measures for addressing both bank-specific and broader systemic risks, the key challenge in this revision of the Core Principles has been to uphold their relevance for different jurisdictions and banking systems," stated Ms Teo Swee Lian, Co-chair of the Core Principles Group and Deputy Managing Director of the Monetary Authority of Singapore. "As highlighted in the paper, a proportionate approach achieves this through advocating risk-based supervision and supervisory expectations that are commensurate with a bank's risk profile and systemic importance."

The revised Core Principles represented the collective efforts between the Basel Committee and other banking supervisors from around the world, as well as the International Monetary Fund and the World Bank.

For information purposes, a document comparing the 2006 assessment methodology with the revised version has also been posted. This document is provided to facilitate a direct comparison between the two versions of assessment criteria.

The Basel Committee welcomes comments on the revised Core Principles. Comments should be submitted by Tuesday 20 March 2012 by email to: baselcommittee@bis.org. Alternatively, comments may be sent by post to the Secretariat of the Basel Committee on Banking Supervision, Bank for International Settlements, CH-4002 Basel, Switzerland. All comments may be published on the Bank for International Settlements's website unless a commenter specifically requests confidential treatment.


PDF: http://www.bis.org/publ/bcbs213.pdf (84 pages)

BCBS: Proposed regulatory capital disclosure requirements

Proposed regulatory capital disclosure requirements issued by the Basel Committee

December 19, 2011

http://www.bis.org/press/p111219a.htm

The Basel Committee on Banking Supervision today published for consultation a set of requirements for banks to disclose the composition of their regulatory capital. These aim to improve the transparency and comparability of banks' capital bases, including on a cross border basis.

During the financial crisis, market participants and supervisors attempted to undertake detailed assessments of the capital positions of banks and make cross jurisdictional comparisons. These efforts were often hampered by insufficiently detailed disclosure and a lack of consistency in reporting between banks and across jurisdictions. A lack of clarity on the quality of capital may have contributed to uncertainty during the financial crisis.

In addition to improving the quality and level of required capital, Basel III established certain high level disclosure requirements to improve transparency of regulatory capital and enhance market discipline. The Basel Committee noted that it would issue more detailed Pillar 3 disclosure requirements in 2011. Today's publication sets out these detailed requirements for consultation.

The Basel Committee welcomes comments on the proposed consultative document. Comments should be submitted by Friday 17 February 2012 by email to: baselcommittee@bis.org. Alternatively, comments may be sent by post to the Secretariat of the Basel Committee on Banking Supervision, Bank for International Settlements, CH-4002 Basel, Switzerland. All comments may be published on the Bank for International Settlements's website unless a commenter specifically requests confidential treatment.

Joint Forum: Consultative paper on "Principles for the supervision of financial conglomerates"

Consultative paper on "Principles for the supervision of financial conglomerates" released by the Joint Forum
December 19, 2011

The Joint Forum released today a consultative paper on Principles for the Supervision of Financial Conglomerates.

The proposed principles, which revise the Joint Forum's 1999 principles, provide national authorities, standard setters and supervisors with a set of internationally agreed principles that support consistent and effective supervision of financial conglomerates and in particular those financial conglomerates that are active across borders.

Mr Tony D'Aloisio, Chairman of the Joint Forum, stated that "these principles should, over time, help strengthen the global financial system through more effective and consistent oversight and supervision of financial conglomerates notably including risks arising from unregulated financial activities and entities".

The financial crisis that began in 2007 exposed situations in which regulatory requirements and oversight did not fully capture all the activities of financial conglomerates or fully consider the impact and cost that these activities may pose to the financial system. The principles issued today address complexities and gaps resulting from cross-sectoral activities with a scope of application based on a revised and broader definition of a financial conglomerate.

The proposed principles are organised into five sections and expand on and supplement the 1999 Principles in a number of ways:


Supervisory powers and authority

The principles are directed to both policy makers and supervisors highlighting the need for a clear legal framework that provides supervisors with the necessary powers, authority and resources to perform, with independence and in coordination with other supervisors, comprehensive group-wide supervision.


Supervisory responsibility

The principles reaffirm the importance of supervisory cooperation, coordination and information exchange. They clarify the importance of identifying a group-level supervisor whose responsibility is to focus on group-level supervision and the facilitation of coordination between relevant supervisors. New principles have been included which relate to the role and responsibilities of supervisors in implementing minimum prudential standards, monitoring and supervising activities of financial conglomerates and taking corrective action as appropriate.


Corporate governance

The principles reaffirm the importance of fit and proper principles and also provide, through a series of new principles, guidance for supervisors intended to ensure the existence of a robust corporate governance framework for financial conglomerates. These new principles relate to the structure of the financial conglomerate, the responsibilities of the board and senior management, the treatment of conflicts of interest and remuneration policy.


Capital adequacy and liquidity

The principles highlight the role of supervisors in assessing capital adequacy on a group basis, taking into account unregulated entities and activities and the risks they pose to regulated entities. They include new principles on group-wide capital management. The principles also provide guidance on internal capital planning processes that rely on sound board and management decisions, incorporate stressed scenario outcomes, and are subject to adequate internal controls. A new principle on liquidity assessment and management is also introduced - providing guidance for supervisors intended to ensure that financial conglomerates properly measure and manage liquidity risk.


Risk management

The principles set out the need for a financial conglomerate to have a comprehensive risk management framework to manage and report group-wide risk concentrations and intra-group transactions and exposures. Greater emphasis is placed on the financial conglomerate's ability to measure, manage and report all material risks to which it is exposed, including those stemming from unregulated entities and activities. The principles focus on group-wide risk management culture and appropriate tolerance levels; addressing risks associated with new business areas and outsourcing; group-wide stress-tests and scenario analyses for the prudent aggregation of risks; bringing off-balance sheet activities within the scope of group-wide supervision.


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The consultative report is available on the websites of the Bank for International Settlements (www.bis.org), IOSCO (www.iosco.org) and the IAIS (www.iaisweb.org). Comments on this consultative report should be submitted by Friday 16 March 2012 either by email to baselcommittee@bis.org or by post to the Secretariat of the Joint Forum (BCBS Secretariat), Bank for International Settlements, CH-4002 Basel, Switzerland. All comments may be published on the websites of the Bank for International Settlements, IOSCO (www.iosco.org) and the IAIS (www.iaisweb.org) unless a commenter specifically requests confidential treatment.

Link to this press release: http://www.bis.org/press/p111219b.htm
Link to the PDF: http://www.bis.org/publ/joint27.pdf

Bank Competition and Financial Stability: A General Equilibrium Exposition

Bank Competition and Financial Stability: A General Equilibrium Exposition. By Gianni De Nicolo' & Marcella Lucchetta
IMF Working Paper No. 11/295
Dec 16, 2011

Summary: We study versions of a general equilibrium banking model with moral hazard under either constant or increasing returns to scale of the intermediation technology used by banks to screen and/or monitor borrowers. If the intermediation technology exhibits increasing returns to scale, or it is relatively efficient, then perfect competition is optimal and supports the lowest feasible level of bank risk. Conversely, if the intermediation technology exhibits constant returns to scale, or is relatively inefficient, then imperfect competition and intermediate levels of bank risks are optimal. These results are empirically relevant and carry significant implications for financial policy.

Excerpts:

The theoretical literature offers contrasting results on the relationship between bank competition and financial stability. Yet these results arise from models with three important limitations: they are partial equilibrium set-ups; there is no special role for banks as institutions endowed with some comparative advantage in screening and/or monitoring borrowers; and bank risk is not determined jointly by the borrower and the bank. This paper contributes to overcome these limitations. A more general assessment of the relationship between bank competition, financial stability and welfare is not only important per se, but it is also essential to evaluate whether “granting” banks the ability of earning rents may reduce their risk-taking incentives.

We study the relationship between bank competition, financial stability and welfare in versions of a general equilibrium banking model with moral hazard, where the choice of “systematic” risk by either banks or firms is unobservable. In our set-up, risk-neutral agents specialize in production at the start date, choosing to become entrepreneurs, bankers, or depositors, and at a later date they make their financing and investment decisions. In this risk-neutral world, the welfare criterion is total surplus, defined as total output net of effort costs. We consider two versions of the model. In the first version, called “basic”, the bank is a coalition of entrepreneurs that are financed by depositors. In the second version, called “extended”, the “firm” is a coalition of entrepreneurs that is financed by the “bank”, which is a coalition of bankers financed by depositors. The firm, the bank and depositors can be also viewed as representing the business sector, the banking sector and the household sector.

In both versions, we consider two specifications of the bank’s screening and/or monitoring technology, called the “intermediation technology”. In the first specification, the intermediation technology exhibits constant returns to scale: the effort cost of screening and/or monitoring is proportional to the size of investment. In the second specification, this technology exhibits increasing returns to scale: the effort cost of screening and/or monitoring is independent of investment size. This second specification captures in a simple form the essential role of banks in economizing on monitoring and screening costs identified by a well-known literature briefly reviewed below.

In the basic model the bank chooses (systematic) risk, this choice is unobservable to outsiders, and there is competition in the deposit market only, indexed by the opportunity costs of depositors to invest in the bank. The results of this model differ strikingly depending on whether the intermediation technology exhibits constant or increasing returns to scale.  Under constant returns to scale, as competition in the deposit market increases, bank risk increases, bank capital declines, and welfare is maximized for some intermediate degree of competition. Thus, perfect deposit market competition is sub-optimal, as it entails excessive bank risk-taking and sub-optimally low levels of bank capitalization. However, allocating large shares of surplus (or rents) to banks is not optimal either, as it results in sub-optimally low levels of bank-risk taking and excessive bank capitalization.

When the intermediation technology exhibits increasing returns to scale, however, results are totally reversed: as competition increases, bank risk declines, capitalization increases, perfect deposit market competition is optimal, and the lowest feasible level of bank risk is best. This reversal is simply explained as follows. As competition increases, a ceteris paribus increase in the cost of funding induces the bank to take on more risk. But at the same time the increase in the supply of funds to the bank reduces the costs of the intermediation technology owing to increasing returns to scale: this offsets the negative impact of higher funding costs on bank’s expected profits, inducing the bank to take on less risk. This result is remarkable for two reasons: it is obtained under a standard assumption about the bank’s intermediation technology, and without modeling loan market competition. Thus, introducing loan market competition, as in Boyd and De Nicolo’ (2005), is not necessary—albeit it may be sufficient—to yield a positive relationship between bank competition and financial stability.

The extended model depicts the more realistic case in which there is competition in both lending and deposit markets, bank risk is jointly determined by borrowers and banks, and setting up the intermediation technology entails set-up costs. Here, bank competition is indexed by the opportunity costs of depositors to invest in the bank, and the opportunity costs of the firm to be financed by the bank. In this model, the relationship between bank competition, financial stability, and welfare becomes complex in a substantial economic sense, since double-sided competition determines how total surplus, whose size is endogenous, is shared by three sets of agents, rather than two, as in the basic model. When the degree of competition in lending and deposit markets differs, we illustrate several results suggestive of a rich comparative statics, which in some cases overturn simple conjectures on the relationship between bank risk, firm risk and capital.

Focusing on changes of competition in both loan and deposit markets, we obtain the following main results. If the bank intermediation technology is relatively inefficient, as defined as one that entails high monitoring and screening costs but relatively low set-up costs, then a level of competition lower than perfect competition is optimal, corresponding to an “intermediate” optimal levels of bank risk. However, if the bank intermediation technology is relatively efficient, defined as one that entails low monitoring and screening costs but relatively large set-up costs, then perfect competition is optimal, and the optimal level of bank risk turns out to be the lowest attainable. Notably, these results are independent of whether the intermediation technology exhibits constant or increasing returns to scale in screening and/or monitoring effort.

We discuss below the empirical relevance of some of our results. Furthermore, we believe these results throw a new light on the important policy question regarding the desirability of supporting bank profits, or banks’ “charter value”, with some “rents” in order to guarantee financial stability: what seems to matter are not necessarily rents per se, but what are their sources and how banks might exploit them.

Conclusions:

We studied versions of a general equilibrium banking model with moral hazard in which the bank’s intermediation technology exhibits either constant or increasing returns to scale. In the basic version of the model under constant returns of the intermediation technology we showed that as deposit market competition increases, bank risk increases, capitalization declines, and “intermediate” degreed of deposit market competition and bank risk are best..The result that the lowest attainable level of bank risk is not optimal echoes Allen and Gale’s (2004b) result that a positive degree of financial ”instability” can be a necessary condition for optimality. Yet, the efficiency of the intermediation technology matters. If this technology exhibits increasing returns to scale, then the implications of this model for bank risk, capitalization and welfare are totally reversed: as competition increases, bank risk declines, capitalization increases, perfect deposit market competition and the lowest attainable level of bank risk are optimal.

Subsequently, we studied the more realistic version of the model where there is competition in both lending and deposit markets and bank risk is determined jointly by the bank and the firm. The key results of the extended model pertain to the role of the efficiency of the intermediation technology in relationship to the level of competition in both lending and deposit markets. We showed that independently of whether the intermediation technology exhibits constant or increasing returns, perfect competition and the lowest attainable level of bank risk are optimal if the bank intermediation technology is relatively efficient. When such technology is relatively inefficient, however, perfect competition is suboptimal, and intermediates levels of competition and bank risk are best.

The theoretical results or our study are empirically relevant. Several studies present evidence consistent with a positive relationship between bank competition and financial stability.  Jayaratne and Strahan (1998) find that branch deregulation resulted in a sharp decrease in loan losses. Restrictions on banks’ entry and activity have been found to be negatively associated with some measures of bank stability by Barth, Caprio and Levine (2004), Beck (2006a and 2006b), and Schaeck et al. (2009). Furthermore, Cetorelli and Gambera (2001) and Cetorelli and Strahan (2006) find that banks with market power erect an important financial barrier to entry to the detriment of the entrepreneurial sector of the economy, leading to long-term declines in a country’s growth prospect. Lastly, Corbae and D’Erasmo (2011) present a detailed quantitative study of the U.S. banking industry based on a dynamic calibrated version of Boyd and De Nicolo’ (2005) model, finding evidence of a positive association between competition and financial stability. It is apparent that these results are consistent with the predictions of the basic model with increasing returns, and those of the extended model in which banks use relatively efficient intermediation technologies.

Under a policy viewpoint, we believe that our results provide an important insight with regard to the question of whether supporting bank profits with some rents—or, in a dynamic context, supporting banks’ charter values—is a desirable public policy option. A substantial portion of the literature and the policy debate maintains that preserving bank profitability through rents enhancing bank profitability—or banks’ charter values—may be desirable, as it induces banks to take on less risk. As we have shown, however, this argument ignores how these rents are generated, or how they may be eventually used once granted.

Our results suggest that supporting bank profitability (or charter values) with rents that are independent of bank’s actions aimed at improving efficiency may be unwarranted. If rents accrue independently of banks’ efforts to adopt more efficient intermediation technologies and, more generally, to provide better intermediation services, then rents are suboptimal and do not guarantee banking system stability. In this light, competitive pressures may be an effective incentive for banks to adopt more efficient intermediation technologies. In a competitive environment, rents would need to be earned by investing in technologies that provide banks a comparative advantage in providing intermediation services, rather than been derived from some market power enjoyed “freely”.

Source: http://www.imf.org/external/pubs/cat/longres.aspx?sk=25439.0

BCBS: The internal audit function in banks - consultative document

The internal audit function in banks - consultative document
The Basel Committee on Banking Supervision, December 2, 2011

The Basel Committee on Banking Supervision is issuing this revised supervisory guidance for assessing the effectiveness of the internal audit function in banks, which forms part of the Committee's ongoing efforts to address bank supervisory issues and enhance supervision through guidance that encourages sound practices within banks. The document replaces the 2001 document Internal audit in banks and the supervisor's relationship with auditors. It takes into account developments in supervisory practices and in banking organisations and incorporates lessons drawn from the recent financial crisis.

The document builds on the Committee's Principles for Enhancing Corporate Governance [http://www.bis.org/publ/bcbs176.htm] which require banks to have an internal audit function with sufficient authority, stature, independence, resources and access to the board of directors. Independent, competent and qualified internal auditors are vital to sound corporate governance.

As a strong internal control framework including an independent, effective internal audit function is part of sound corporate governance. Banking supervisors must be satisfied as to the effectiveness of a bank's internal audit function, that effective policies and practices are followed and that management takes appropriate corrective action in response to internal control weaknesses identified by internal auditors. An effective internal audit function provides vital assurance to a bank's board of directors and senior management (and bank supervisors) as to the quality of the bank's internal control system. In doing so, the function helps reduce the risk of loss and reputational damage to the bank.

The document is based on 20 principles, organised in three sections: A) Supervisory expectations relevant to the internal audit function, B) The relationship of the supervisory authority with the internal audit function, and C) Supervisory assessment of the internal audit function. This approach seeks to promote a strong internal audit function within banking organisations and addresses supervisory expectations for the internal audit function and the supervisory assessment of that function. It also encourages bank internal auditors to comply with and to contribute to the development of national and international professional standards, such as those issued by The Institute of Internal Auditors, and it promotes due consideration of prudential issues in the development of internal audit standards and practices. An annex to the consultative document details responsiblities of a bank's audit committee.

The Basel Committee welcomes comments on the proposed consultative document. Comments should be submitted by Friday 2 March 2012 by email to: baselcommittee@bis.org. Alternatively, comments may be sent by post to the Secretariat of the Basel Committee on Banking Supervision, Bank for International Settlements, CH-4002 Basel, Switzerland. All comments may be published on the Bank for International Settlements's website unless a commenter specifically requests confidential treatment.

You can download the PDF from here: http://www.bis.org/publ/bcbs210.htm


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Press release: Banks' internal audit function - consultative paper issued by the Basel Committee
December 2, 2011
http://www.bis.org/press/p111202.htm

The Basel Committee on Banking Supervision issued today a consultative paper on The internal audit function in banks.

The objective of the proposed guidance, which revises the Committee's 2001 document Internal Audit in Banks and the Supervisor's Relationship with Auditors, is to help supervisors assess the effectiveness of a bank's internal audit function. The guidance reflects developments in supervisory and banking practices and incorporates lessons drawn from the financial crisis.

The proposed guidance is built around a set of principles that seek to promote a strong internal audit function within banks. The principles cover supervisory expectations related to the internal audit function as well as the supervisory assessment of that function. The principles also review the relationship between a supervisory authority and a bank's internal audit function.

The Basel Committee welcomes comments on the proposed consultative documents. Comments should be submitted by Friday, 2 March 2012 by email to: baselcommittee@bis.org. Alternatively, comments may be sent by post to the Secretariat of the Basel Committee on Banking Supervision, Bank for International Settlements, CH-4002 Basel, Switzerland. All comments may be published on the Bank for International Settlements's website unless a commenter specifically requests confidential treatment.

The Committee is now in the process of developing supervisory guidance on external audit. This guidance will build on existing Basel Committee guidance on this topic, including The relationship between bank supervisors and external auditors (2002) and External audit quality and banking supervision (2008). The Committee expects to publish a consultative version of its external audit guidance in 2012.

Over 900 Biotechnology Medicines in Development, Targeting More than 100 Diseases

Over 900 Biotechnology Medicines in Development, Targeting More than 100 Diseases
September 14, 2011
http://www.innovation.org/index.cfm/FutureOfInnovation/NewMedicinesinDevelopment/Biotechnology_Medicines

Biotechnology has opened the door to the discovery and development of new types of human therapeutics. Advancements in both cellular and molecular biology have allowed scientists to identify and develop a host of new products. These cutting-edge medicines provide significant clinical benefits, and in many cases, address therapeutic categories where no effective treatment previously existed.

Innovative, targeted therapies offer enormous potential to address unmet medical needs of patients with cancer, HIV/AIDS, and many other serious diseases. These medicines also hold the potential to help us meet the challenge of rising healthcare costs by avoiding treatment complications and making sure each patient gets the most effective care possible.

Approved biotechnology medicines already treat or help prevent heart attacks, stroke, multiple sclerosis, leukemia, hepatitis, congestive heart failure, lymphoma, kidney cancer, cystic fibrosis, and other diseases. These medicines use many different approaches to treat disease as do medicines currently in the pipeline.

America's biopharmaceutical research companies have 901 biotechnology medicines and vaccines in development to target more than 100 debilitating and life- threatening diseases, such as cancer, arthritis and diabetes, according to a new report [http://www.phrma.org/sites/default/files/1776/biotech2011.pdf] by the Pharmaceutical Research and Manufacturers of America (PhRMA). The medicines in development—all in either clinical trials or under Food and Drug Administration review—include 353 for cancer and related conditions, 187 for infectious diseases, 69 for autoimmune diseases and 59 for cardiovascular diseases.

The biotechnology medicines now in development make use of these and other state-of- the-art approaches. For example:

•A genetically-modified virus-based vaccine to treat melanoma.
•A monoclonal antibody for the treatment of cancer and asthma.
•An antisense medicine for the treatment of cancer.
•A recombinant fusion protein to treat age-related macular degeneration.


SELECTED BIOTECHNOLOGY MEDICINES IN DEVELOPMENT

Autoimmune Diseases: Autoimmunity is the underlying cause of more than 100 serious, chronic illnesses, targeting women 75 percent of the time. Autoimmune diseases have been cited in the top 10 leading causes of all deaths among U.S. women age 65 and younger, representing the fourth largest cause of disability among women in the United States.


Blood Disorders: Hemophilia affects 1 in 5,000 male births. About 400 babies are born with hemophilia each year. Currently, the number of people with hemophilia in the United States is estimated to be about 20,000, based on expected births and deaths since 1994.


Sickle cell disease is an inherited disease that affects more than 80,000 people in the United States, 98 percent of whom are of African descent.


Von Willebrand disease, the most common inherited bleeding condition, affects males and females about equally and is present in up to 1 percent of the U.S. population.


Cancer: Cancer is the second leading cause of death by disease in the United States—1 of every 4 deaths—exceeded only by heart disease. This year nearly 1.6 million new cancer cases will be diagnosed, 78 percent of which will be for individuals ages 55 and older.


Cardiovascular Diseases (CVD): CVD claims more lives each year than cancer, chronic lower respiratory diseases, and accidents combined. More than 82 million American adults—greater than one in three—had one or more types of CVD. Of that total, 40.4 million were estimated to be age 60 and older.


Diabetes: In the United States, 25.8 million people, or 8.3 percent of the population, have diabetes. An estimated 18.8 million have been diagnosed, but 7 million people are not aware that they have the disease. Another 79 million have pre-diabetes. Diabetes is the seventh leading cause of death in the United States.


Genetic Disorders: There are more than 6,000 known genetic disorders. Approximately 4 million babies are born each year, and about 3 percent-4 percent will be born with a genetic disease or major birth defect. More than 20 percent of infant deaths are caused by birth defects or genetic conditions (e.g., congenital heart defects, abnormalities of the nervous system, or chromosomal abnormalities).


Alzheimer’s Disease: In 2010 there were an estimated 454,000 new cases of Alzheimer’s disease. In 2008, Alzheimer’s was reported as the underlying cause of death for 82,476 people. Almost two-thirds of all Americans living with Alzheimer’s are women.


Parkinson's Disease: This disease has been reported to affect approximately 1 percent of Americans over age 50, but unrecognized early symptoms of the disease may be present in as many as 10 percent of those over age 60. Parkinson's disease is more prevalent in men than in women by a ratio of three to two.

Asthma: An estimated 39.9 million Americans have been diagnosed with asthma by a health professional within their lifetime. Females traditionally have consistently higher rates of asthma than males. African Americans are also more likely to be diagnosed with asthma over their lifetime.


Skin Diseases: More than 100 million Americans—one-third of the U.S. population—are afflicted with skin diseases.

Has the global banking system become more fragile over time?

Has the global banking system become more fragile over time? By Deniz Anginer & Asli Demirguc-Kunt
http://www-wds.worldbank.org/external/default/WDSContentServer/WDSP/IB/2011/11/08/000158349_20111108124433/Rendered/PDF/WPS5849.pdf

Abstract: This paper examines time-series and cross-country variations in default risk co-dependence in the global banking system. The authors construct a default risk measure for all publicly traded banks using the Merton contingent claim model, and examine the evolution of the correlation structure of default risk for more than 1,800 banks in more than 60 countries. They find that there has been a significant increase in default risk co-dependence over the three-year period leading to the financial crisis. They also find that countries that are more integrated, and that have liberalized financial systems and weak banking supervision, have higher co-dependence in their banking sector. The results support an increase in scope for international supervisory co-operation, as well as capital charges for "too-connected-to-fail" institutions that can impose significant externalities.

Excerpts:

Introduction

The last decade has seen a tremendous transformation in the global financial sector. Globalization, innovations in communications technology and de-regulation have led to significant growth of financial institutions around the world. These trends had positive economic benefits and have led to increased productivity, increased capital flows, lower borrowing costs, and better price discovery and risk diversification. But the same trends have also led to greater linkages across financial institutions around the world as well as an increase in exposure of these institutions to common sources of risk. The recent financial crisis has demonstrated that financial institutions around the world are highly inter-connected and that vulnerabilities in one market can easily spread to other markets outside of national boundaries.

In this paper we examine whether the global trends described above have led to an increase in co-dependence in default risk of commercial banks around the world. The growing expansion of financial institutions beyond national boundaries over the past decade has resulted in these institutions competing in increasingly similar markets, exposing them to common sources of market and credit risk. During the same period, rapid development of new financial instruments has created new channels of inter-dependency across these institutions. Both increased interconnections and common exposure to risk makes the banking sector more vulnerable to economic, liquidity and information shocks. There is substantial theoretical literature that models the various channels through which such shocks can culminate in a systemic banking crisis (see for instance Bhattacharya and Gale 1987, Allen and Gale 2000, Diamond and Rajan 2005; and focusing on the recent crisis, Brunnermeier 2009, Danielsson, Shin, and Zigrand 2009, Battiston et al. 2009 among others.) To examine whether the global banking sector has become more interdependent and more fragile to shocks, we construct a default risk measure for all publicly traded banks using the Merton (1974) contingent claim model. We compute weekly time series of default probabilities for over 1,800 banks in over 60 countries and examine the evolution of the correlation structure of default risk over the 1998 – 2010 time period.

Our empirical findings show that there has been a substantial increase in co-dependence in default risk of publicly traded banks starting around the beginning of 2004 leading up to the global financial crisis starting in the summer of 2007. Although we observe an overall trend towards convergence in default risk globally, this trend has been much stronger for North American and European banks. We also find that increase in co-dependence has been higher for banks that are larger (with greater than 50 billion in assets). We also examine variation in co-dependence across countries. We find that countries that are more integrated, have liberalized financial systems and weak banking supervision have higher co-dependence in their banking sector.

Increased co-dependence in credit risk in the banking sector has important implications for capital regulations. In the aftermath of the sub-prime crisis of 2007/08, there has been renewed interest in macro-prudential regulation and supervision of the financial system. There has also been a growing consensus to adjust capital requirements to better reflect an individual bank‟s contribution to the risk of the financial system as a whole (Brunnermeier, Crockett, Goodhart, Persaud, and Shin 2009, Financial Stability Forum 2009a, 2009b). Recently a number of papers have tried to measure and quantify systemic risk inherent in the global banking sector. Adrian and Brunnermeier (2009), Huang, Zhou, and Zhou (2009), Chan-Lau and Gravelle (2005), Avesani et al. (2006), and Elsinger and Lehar (2008), use a portfolio credit risk approach to compute the contribution of an individual bank to the risk of a portfolio of banks. Our paper is related to this strand of literature, but our focus is not on quantifying systemic risk of large financial institutions but rather to examine time series trends for a large cross-section of banks. A number of papers have examined the correlation structure of equity returns of a subsample of banks. De Nicolo and Kwast (2002) find rising correlations between bank stock returns in the U.S. from 1988 and 1999. Schuler (2002) find similar results for Europe using a sample from 1980 to 2001. Hawkesby, Marsh and Stevens (2005) analyze co-movements in equity returns for a set of US and European large complex financial institutions using several statistical techniques and find a high degree of commonality. This paper is also related to the literature that studies contagion in financial markets (see among others Forbes and Rigobon 2002, Kee-Hong Bae and Stulz 2003) and also the literature that examines the impact of globalization on convergence of asset prices (Bekeart and Wang 2009, Longin and Solnik 1995, Bekaert and Harvey 2000, and Bekaert, Hodrick and Zhang 2009).

This paper differs from the existing literature in three respects. First, our empirical analyses cast a wider net than the existing literature which focuses only in a particular region or a country and covers a shorter time period. Second we examine time series trends in co-dependence and test for structural changes over time. Finally, we examine cross-country differences in co-dependence and link the differences to measures of financial and economic openness and regulatory frameworks in different countries.

Policymakers may be able to draw important implications from our analysis. Co-dependence in bank default risk has important consequences for systemic stability. We find increasing co-dependence in banks located in different national jurisdictions. Although we do find that strong banking supervision tends to reduce co-dependence in a given country, our results call for banking supervisory co-operation at a global level. This is especially true for larger banks which have grown more interconnected over the past decade.